1. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-1 Chapter 4 The Legal Liability of Auditors

2. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-2 Establishing the Auditor’s Duty Society imposes a duty to exercise reasonable care and skill in two ways: – Contractual (including statutory) relationship – Special relationship between two parties

3. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-3 Reasonable Care and Skill An auditor must exercise the reasonable care and skill expected of a professional. Requires adherence to professional standards in all aspects of an audit. ‘The professional man owes a duty to exercise that standard of skill and care appropriate to his professional status’ (Caparo, 1990). Learning Objective 1:

4. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-4 Negligence Negligence can be classified as any conduct that is careless or unintentional in nature and entails a breach of any contractual duty or duty of care in tort owed to another person or persons. Learning Objective 2:

5. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-5 Negligence of claims To be successful in a claim for negligence, a plaintiff must prove that: – Duty was owed to the plaintiff by the defendant; – A breach of the duty of care (negligent conduct) occurred; – Loss or damage was suffered by plaintiff; and – A causal relationship existed between the breach of duty by defendant and harm suffered by the plaintiff.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-6 Liability to Clients Liability to clients arises both in contract and in the tort of negligence. Early cases include: – London & General Bank Ltd (1895) – Kingston Cotton Mill (1896) – Thomas Gerrard & Son (1967) Learning Objective 3:

7. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-7 Liability to Clients (cont.) — Pacific Acceptance (1970) Auditors’ duties and responsibilities are to: – Use reasonable care and skill; – Check and see for themselves; – Audit the whole year; – Appropriately supervise and review; – Properly document procedures; – Rely on internal controls; – Warn and inform the appropriate level of management; – Take further action where suspicion is aroused; – Structure plans and procedures so that discovery of material error or fraud is reasonably expected; and – Be guided by professional standards (but not determinative).

8. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-8 Liability to clients (cont.) — significant cases Cambridge Credit (1985) Segenhoe (1990) Galoo (1994)

9. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-9 Contributory Negligence Exists where the plaintiff fails to exercise the required standard of care, thus contributing to its own loss. Prior to AWA (1995), such a defence by auditors was unsuccessful. Refer to Pacific Acceptance (1970). Learning Objective 4:

10. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-10 Contributory Negligence — AWA (1995) AWA — the company suffered losses due to internal control weaknesses over foreign exchange. – Auditor liable for failure to report to board of directors. – Company found to contribute to loss by officers failing to report to board of directors and failing to put in place adequate internal control system. – Defence of contributory negligence therefore upheld.

11. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-11 Liability to Third Parties A number of cases have considered the auditor’s liability in relation to persons other than the immediate client. It was believed from early cases (Donoghue v Stevenson (1932)) that the recovery of losses by third parties from auditors for negligence (in the absence of fraud) was not possible. Learning Objective 5:

12. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-12 Liability to Third Parties (cont.) Early test: SPECIAL RELATIONSHIPS A duty is owed to any third party to whom the auditor shows accounts, or to whom the auditor knows the client is going to show accounts, so as to induce some action. – Candler (1951) (per dissenting judgment of Lord Denning); – Hedley Byrne (1963); – MLC v Evatt (1971); and – Shaddock & Associates (1979).

13. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-13 Liability to Third Parties (cont.) Next test: REASONABLE FORESIGHT A duty is owed to a specific third party of whom the auditor was not aware, but who was part of a class of persons of whom they should have been aware: – Scott Group (1978); – JEB Fasteners (1981); and – Twomax (1983).

14. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-14 Liability to Third Parties (cont.) Current test: REASONABLE PROXIMITY Was there a sufficient degree of proximity between the auditor and third party? To answer this question, courts examine whether the report by the auditor was meant to induce the third party to undertake specific actions: – Caparo (1990) – AGC (1992) – Columbia Coffee (1992) (very wide interpretation, later overturned in Esanda) – Esanda (1997) (Full High Court of Australia)

15. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-15 Current situation: Liability to third parties A general conclusion is that it would be hard to show that audits on general purpose financial reports were ever intended to induce third parties to undertake a specific course of action. (Auditors would strongly argue that this was never the intention).

16. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-16 Privity letters A privity letter is a letter from the auditor acknowledging a third party’s reliance on an audited report. The third party requests the privity letter from auditor. Purpose — to establish a relationship with the requisite foreseeability and proximity and thereby establish a duty of care by the auditor to the third party. AGS 1014 provides guidance.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-17 Liability to Third Parties: TRADE PRACTICES ACT Consideration needs to be given to the provisions of the Commonwealth Trade Practices Act and state Fair Trading Acts: – Acts prohibit misleading and deceptive conduct. – It is possible that in issuing an inappropriate audit report, an auditor might be guilty of conduct that is misleading or deceptive.

18. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-18 Criminal liability of auditors Auditors can be subject to criminal prosecution. It is an offence under s. 1308(2) of Corporations Act to knowingly make or authorise false and misleading statements. A penalty of $22,000 and/or five years’ imprisonment exists. Criminal actions against auditors are rare.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-19 Limitation of Liability As of 2005, most audit firms still exist in partnership form. Auditors are currently jointly and severally liable for damages arising from failure by either themselves or their partners to exercise reasonable skill and care. Liability is unlimited. Spiralling litigation costs and court-awarded damages. Professional indemnity insurance is difficult to obtain and prohibitively expensive (claimed to be about 14% of audit revenues). Learning Objective 6:

20. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-20 Arguments for limiting auditors’ liability Inability of auditors to restrict the scope of their operations and/or resign; Inequitable position of the auditing profession compared with other professions and service providers; Inability of auditors to rely on representations of management; and Auditors carry a heavier burden than other professionals with respect to the amount of damages assessed.

21. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-21 Arguments for not limiting auditors’ liability Auditors should accept full responsibility for their work; Auditors are only successfully sued when not performing their duties competently; If there is a limit, auditor’s share of liability passes on to public; and A precedent for other professions.

22. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-22 Methods of limiting auditors’ liability Imposition of a statutory cap on auditors’ liability; – Recommended by JCPAA 2002. – Consider Professional Services Act 1994 - NSW, and Professional Services Bill 2004 - Commonwealth. Incorporation of auditors; and – Recommended by both JCPAA and CLERP 9, 2002. Replacement of joint and several liability with proportionate liability. – Recommended by both JCPAA and CLERP 9, 2002.

23. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-23 Changes to auditor liability Recent changes to Corporations Act 2001 as a result of CLERP 9 Bill 2004 allow: – auditors to incorporate and form authorised audit companies with adequate and appropriate professional indemnity insurance. – apportionment between plaintiff and defendant according to blame, and proportionate liability if there are two or more defendants.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-24 Responsibility for the Prevention and Detection of Fraud Guidance: AUS 210/ASA 240 (ISA 240) for fraud and error – Prevention of fraud is management’s responsibility. Auditor has responsibility to: – Plan so they have reasonable expectation of detecting irregularities; – Pursue any suspicions further; and – Report fraud to appropriate level of management, irrespective of materiality. Learning Objective 7:

25. Copyright  2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger Simnett Slides prepared by Roger Simnett 4-25 Responsibility for the reporting of fraud Auditor has a duty of care to report fraud, irrespective of materiality, to an appropriate level of management when suspicions are aroused. Auditor may have a mandatory responsibility to report fraud under the Corporations Act or the Crimes Act. Auditor is protected by qualified privilege when reporting matters in good faith.